The DC Circuit Should Invalidate The Net Worth Sweep Of Fannie/Freddie Assets

A motley collection of procedural objections should not block a long overdue decision

In the aftermath of oral argument of April 15, 2016 in Perry Capital v. Lew, there has been an unusual flurry of briefing activity, which clearly reflects the high stakes of this undecided case. Up through the oral argument, the focus had been on the merits of the net worth sweep (NWS) introduced by the Third Amendment to Senior Preferred Stock Purchase Agreements (SPSPAs) in August 2012. The D.C. Circuit was curious about whether it should reach the substantive issues at all, given lurking complications with the doctrine of sovereign immunity. I wrote an extensive analysis that concluded that there was nothing of merit in this diversionary action. And so it has turned out. All the parties agreed that the sovereign immunity defense was available neither to FHFA nor to Treasury. The upshot of that detour is that the correct analysis of this case begins and ends with observation that the NWS was introduced by contract and thus should be analyzed not as a regulatory action, but under ordinary contract rules. Sadly, no one could think of the NWS as a legitimate modification for mutual benefit of the original 2008 agreement, when Treasury got not something, but everything, from its sweetheart deal with FHFA. The private shareholders get nothing, come hell or high water. If the NWS sticks, they should be wholly indifferent to the fortunes of a business in which they no longer have a stake.

The weakness of its substantive position makes the government all too eager to put procedural obstacles in the path of letting the Circuit Court decide the merits of the NWS on the merits. The latest permutation on this point came in the FHFA briefing submitted on April 22, 2016 on the question of whether 17 U.S.C. § 4623, which addresses judicial review of Director action places some procedural obstacle in the path of the litigation. There is nothing to the point. In analyzing the question, the government places inordinate weight on subsection (d), which provides:

(d)Limitation on jurisdiction: “Except as provided in this section, no court shall have jurisdiction to affect, by injunction or otherwise, the issuance or effectiveness of any classification or action of the Director under this subchapter (other than appointment of a conservator under section 4616 or 4617 of this title or action under section 4619 of this title) or to review, modify, suspend, terminate, or set aside such classification or action.

The opening words include a reference to subsection (b), which allows for a review of any such classification or action under an arbitrary and capricious standard, which means that there is no absolute jurisdictional bar for the review, and which would surely doom the Third Amendment for its collusive destruction of private rights, without hearing or notice to the affected people. But more importantly, Section 4623, to which no earlier reference was made by any party during the entire history of this protracted litigation, only applies to capital classifications and regulatory actions. That section governs the unilateral decisions that the government makes, but it does not cover the contracts entered into by Director with Treasury, which must stand or fall on their own merits. In addition, it is worth noting that Section 4617 imposes the duty as conservator on the Agency, not just the Director, and its actions are not covered at all by section 4623 which is not directed at all to conservatorship or the actions of FHFA as conservator. Once again the result is too clear to require extensive discussion. Section 4623 is an irrelevant diversion.

At this point then the case stands or falls on whether FHFA and Treasury acted beyond their powers. It is not worthwhile to rehash all the arguments that they did. But it is worth noting that one of the most incorrigible defenders of the NWS, John Carney of the Wall Street Journal once again demonstrates his abysmal lack of financial acumen. In his most recent post, “Hopes Dim For Freddie Mac Shareholders”, Carney takes the view that the recent poor financial performance at Freddie Mac “bolsters the government’s claim that the 2012 deal actually aides [sic] the company by relieving it of a fixed obligation in tougher quarters.”

Not so. Carney initially misses the obvious point that fiduciary duties were owed not to the “company” after it was taken over by the government when the private shareholders were wiped out. Instead, fiduciary duties were owed to the private shareholders who got nothing whatsoever out of this deal. Nor does Carney’s financial analysis make the slightest sense. His explicit frame of reference compares the amount of the payments owed by Freddie Mac prior to the NWS sweep with the limited cash now available to pay quarterly dividends in cash on the government’s maximum $187 billion of senior preferred stock outstanding. But in so doing he ignores that the proper characterization of the money paid over as a return of capital would have reduced the outstanding amount of senior preferred stock, and with it the need for dividend payments.

This issue, which also matters in the parallel analysis of Fannie Mae, is no small deal. Jeremy Cain has published an exhaustive analysis of the financial situation, which concludes:

Fannie Mae and Freddie Mac have paid exceedingly more money in dividends under the NWS ($200.1 billion) than the original 10% dividend ($33.55 billion) if the money they have paid since NWS had been used to pay down debt! Under this scenario the GSEs would only owe Treasury a liquidation preference of $22.9 billion, as opposed to the current $187.5 billion due to Treasury sweeping $200.1 billion in dividends with the NWS. Even if the GSEs had used the cash to build up their capital reserves, the dividends would have been $75 billion during the NWS time period (~ last 4 years), and the GSEs would have $125 billion in capital reserves stored up,

Carney is also wrong for yet another reason, because he falsely assumes that under the SPSPAs, the Treasury would have to bail out Freddie Mac (or Fannie Mae) with additional cash contributions. But that is not what the agreement provides for. The Treasury need not make any new advances, but more importantly, Freddie Mac (like Fannie Mae) has the unlimited option to defer payments—the so-called “in-kind” option— so long as it is prepared to pay dividends at a 12% annual rate on the outstanding amount of senior preferred stock. Even that extra dividend payment would not be required if the company received credits as a return of capital for the excess payments made to Treasury under the NWS.

In this particular case, then, the only serious difficulty is the choice of remedy for what is on the first theory a breach of fiduciary duty and on a second theory a stripping of the assets from the companies without just, indeed any, compensation at all. These two theories are litigated on separate tracks, where the takings claim is now in the epic Court of Claims litigation in Fairholme v. United States, so not enough attention is given to their interaction. In a takings case, the amount of damages is equal to the losses imposed by the government action, fixed as of the date of the taking, plus interest thereafter. Future changes in the fortune of Fannie and Freddie are thus wholly irrelevant because on this view the government owns the company by exercise of its power of compulsory purchase. Hence the longer the delay in paying compensation, the greater its interest obligation.

In contrast, under the breach of fiduciary theory the government does not take ownership of the company, but is required to make restitution for its action so as to return the position to the extent possible to the status quo ante, which means that the private shareholders still retain their equity stake, and are thus subject to the risk of market fluctuations. As noted earlier, this approach requires a credit to the private shareholders for overpayments made to the government under the NWS. But the restoration of the status quo ante means that the shareholders are still intimately concerned with the operations of the company in which they have a residual stake. Indeed, perhaps the strongest reason to end the conservatorship is that there is under current law no way that these shareholders can challenge FHFA in its administration of Fannie and Freddie assets. It is always risky business to have a faithless trustee in charge, and that is what seems to be the case here. It should be evident that the entire matter has been mishandled from start to finish. It is time for the Circuit Court to set matters right.

Richard A. Epstein is the Laurence A. Tisch professor of Law at NYU, senior fellow at the Hoover Institution, and senior lecturer at the University of Chicago Law School.